Puerto Rico is $72 billion in debt over its head, and it's going to take a painful process to bring the island's finances back from the brink. It's a massive debt load for such a small territory, and the problem can really be traced to one issue — bad tax policy. After Puerto Rico let one tax break for manufacturers expire almost a decade ago, manufacturers started shutting down operations on the island. That caused a spike in unemployment. On top of that, business friendly tax policies for some of the companies that remained allowed multi-national giants to pay tax rates of little more than 1%. Plus, Puerto Rico's large underground economy meant the island also struggled to collect taxes from some of its citizens. With revenue slowing, Puerto Rico decided to raise billions in debt to finance its government operations. Investors were willing to loan Puerto Rico money, despite the economic warning signs, because it offered high yields, and the island's bonds had attractive tax breaks. "The tax system in Puerto Rico is very regressive," says debt expert Larry McDonald of Newedge. He has been investing in its debt since 2013 and started warning about the island's precarious situation last year. "The population is down by 1 million people. All the talent left the island because of really bad government policy," he said. The exodus started back in 2006, when a tax break for manufacturers who set up shop on the island was allowed to expire. Employment fell around 10 percentage points between 2006 and 2010, according to a report by the New York Federal Reserve. The island's malaise was of course exacerbated by the financial crisis on the mainland. But whereas the economy on the mainland made a steady recovery in the aftermath of the crash, economic activity on the island continued to nosedive. Nobody pays As the economy continued its descent, the government simply couldn't collect enough tax revenue to finance its operations. One reason for that is because a lot of the remaining companies with a presence on the island barely had to pay any taxes. Microsoft for example packages and ships its products from Puerto Rico. Thanks to what the government considered business friendly policies, it enjoyed a 1.02% tax rate in 2011. "And it isn't just Microsoft," said McDonald. "It's dozens of companies." It's also hard to tax a significant percentage of the population's income because many Puerto Ricans work in the underground economy. "While the underground economy is difficult to measure accurately, estimates of its size are on the order of 23 percent of GNP," the NY Fed said in its report. "The magnitude of this sector suggests that a relatively large fraction of economic activity in Puerto Rico is unrecorded and not currently subject to either income or sales taxes." And investors loved it None of the above stopped investors from rushing in to buy Puerto Rico's bonds. Why? High yields in a low interest rate environment and another tax break — three of them to be precise. Puerto Rico's bonds are exempt of local, federal and state income taxes. "It was politically favorable for the Commonwealth because they were able to do these things [like issuing bonds] and not put the burden on the residents," said David Fernandez, a public finance lawyer at Buchanan, Ingersoll & Rooney. "They kept doing it and doing it and the market kept buying and buying. Who wouldn't do that?" The result of that, though, was that Puerto Rico started racking up debt it had no hope of paying off. That is why, at the end of the June, Puerto Rico's Governor, Alejandro García Padilla, sent out an S.O.S message. He said that his government would soon be unable to make payments to the territory's bondholders — it simply didn't have the money. "My administration is doing everything not to default," Gov. Alejandro García Padilla said at the time. "But we have to make the economy grow," he added. "If not, we will be in a death spiral." The administration did not avoid default. On August 1st it only paid a tiny portion of the $58 million its Public Finance Corp. owed to investors. The spiral had begun. What's more, Puerto Rico cannot file for bankruptcy simply because its government was not given the right to allow its entities to go through Chapter 9 when the federal bankruptcy act was written. Puerto Rico tried to pass a law changing that, but the investors who so enjoyed its tax policies challenged the law in court. They argued that the bankruptcy process would change the value of the bonds they purchased. There's no appetite in Washington to change bankruptcy laws to allow Puerto Rico to file either. What's most likely is that a committee will be set up to figure out how to organize Puerto Rico's debt load. "Just because Puerto Rico can't file bankruptcy doesn't mean they can't come up with a bankruptcy like solution," said Michael Sweet, a partner at law firm Fox Rothschild. Economists paid by the islands investors have also urged the island to implement a regime of tax increases and budget cuts, otherwise known as a policy of austerity. Like the Germans There's support for that in Congress too. "The Republicans are like the Germans," said McDonald, referring to the Germany's hard line stance on Greek austerity as that nation goes through its own debt crisis. That may not be the best way to go in this situation according to the New York Fed's report. "In an environment where income is not growing, government austerity measures to address fiscal deficits can potentially weaken the economy further in the short run— through, for example, layoffs of public employees or increases in taxes," it said. "Fiscal policies to put debt levels on a more sustainable path in Puerto Rico will need to limit potentially adverse effects on an already weak economy." For now, it's unclear what will happen next. It seems the government is carefully choosing which of its agencies will have to default. Sweet at Fox Rothschild described the way the government let its first entity default as "strategic". He said: "I do think that a facilitated restructuring of the debt on a level that allows the government to stretch things out, the kind of thing you might see in a bankruptcy without going through bankruptcy, is where this thing needs to go and it's where the government is trying to go." The government is trying to ensure that Puerto Ricans continue to receive government services, that intelligent workers stay on the island, and that employment holds up. Investors meanwhile would rather force austerity. Those two things look incompatible, and the crunch point could be just around the corner. "We don't know specifically when the cash starts to hit the bone," said McDonald. "But I would say between now and November 1st." That's how fast all of this is going down. Very, very fast. Join the conversation about this story » NOW WATCH: 9 non-chemical ways to fall asleep super fast
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